What Exactly Is Behavioral Finance Essay

Traditional economics describes human beings as rational decision makers , but it has been observed that investor do not always act rationally. Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient (Sewell, 2001). SEWELL, Martin, 2001. Behavioural finance. http://www.behaviouralfinance.net/ . Behavioral finance in recent times become a issue of significant interest to investors because it is a relatively new and evolving field in economics and consequently not well defined, a legitimate question is: "What exactly is behavioral finance?" but it is Described in various ways i.e. Behavioral finance is the integration of classical economics and finance with psychology and the decision-making sciences or an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature or the study of how investors systematically make errors in judgement, or "mental mistakes." All economic models make simplifying assumptions about both market conditions and the behavior of market participants. Sometimes the simplifying assumptions underlying the model are explicitly stated and sometimes the assumptions are implicit, the latter is often the case regarding the behavioral assumptions underlying the model. To illustrate, consider the efficient market hypothesis (EMH), an economic model of considerable importance to investors. The simplifying assumptions regarding market conditions that underlie the EMH frequently include, among others, assumptions such as: Transaction costs are zero, Markets are not segmented, Easy (even unlimited) entry into the security markets exists. The behavioral assumptions that underlie the Efficient Market Hypothesis can be expressed as: Investors act, in an unbiased fashion, to maximize the value of their portfolios, Investors always act in their own self-interest. The first behavioral assumption is frequently stated as investors are "rational expectations wealth maximizers" this means that investors form unbiased expectations of the future and given these expectations, they buy and sell in the securities markets at prices which they believe will maximize the future value of their portfolios. Behavioral finance questions whether the behavioral assumptions underlying the EMH are true. For example, consider the assumption that individuals always act in their economic self-interest. Suppose you are having dinner at an out-of-town restaurant and it is extremely unlikely that you will ever return to this restaurant. Do you leave a tip? Most people do, but in this case leaving a tip decreases, rather than increases one's wealth, and because you won't be returning to this restaurant there are (presumably) no "costs" associated with not leaving a tip. In this case leaving a tip violates the rational expectations and self-interest assumptions. More germane to the EMH, consider "social investing" such as arbitrarily deciding not to invest in tobacco stocks or deciding to overweight environmentally clean industries, etc. Such behavior is not consistent with pure wealth maximization, if for no other reason than opportunities for forming better-diversified portfolios are foregone. Why investors might engage in non-wealth maximizing behavior, and what are the implications of such behavior for security pricing, are areas of inquiry in behavioral finance. Another aspect of behavioral finance concerns how investors form expectations regarding the future and how these expectations are transformed into security prices. Researchers in cognitive psychology and the decision sciences have documented that, under certain conditions, people systematically make errors in judgement or mental mistakes. These mental mistakes can cause investors to form biased expectations regarding the future that, in turn, can cause securities to be mispriced. By considering that investors may not always act in a wealth maximizing manner and that investors may have biased expectations, behavioral finance may be able to explain some of the anomalies to the EMH that have been reported in the finance literature.Anomalous returns such as those associated with "value" stocks, earnings surprises etc Cognitive psychologists have documented many patterns regarding how people behave. Some of these patterns are as follows:

Heuristics

Heuristics, or rules of thumb, make decision-making easier. But they can sometimes lead to biases, especially when things change. These can lead to suboptimal investment decisions. When faced with N choices for how to invest retirement money, many people allocate using the 1/N rule. If there are three funds, one-third goes into each. If two are stock funds, two-thirds goes into equities. If one of the three is a stock fund, one-third goes into equities. (Benartzi and Thaler, 2001)

Overconfidence

People are overconfident about their abilities. Entrepreneurs are especially likely to be overconfident. Overconfidence manifests itself in a number of ways. One example is too little diversification, because of a tendency to invest too much in what one is familiar with. Thus, people invest in local companies, even though this is bad from a diversification viewpoint because their real estate (the house they own) is tied to the company's fortunes. Think of auto industry employees in Detroit, construction industry employees in Hong Kong or Tokyo, or computer hardware engineers in Silicon Valley. People invest way too much in the stock of the company that they work for. Men tend to be more overconfident than women. This manifests itself in many ways, including trading behavior. According to Barber and Odean they analyzed the trading activities ofpeople with discount brokerage accounts. They found that the more people traded, the worse they did, on average. And men traded more, and did worse than, women investors.

Mental Accounting

People sometimes separate decisions that should, in principle, be combined. For example, many people have a household budget for food, and a household budget for entertaining. At home, where the food budget is present, they will not eat lobster or shrimp because they are much more expensive than a fish casserole. But in a restaurant, they will order lobster and shrimp even though the cost is much higher than a simple fish dinner. If they instead ate lobster and shrimp at home, and the simple fish in a restaurant, they could save money. But because they are thinking separately about restaurant meals and food at home, they choose to limit their food at home.

Framing

Framing is the notion that how a concept is presented to individuals matters. For example, restaurants may advertise "early-bird" specials or "after-theatre" discounts, but they never use peak-period "surcharges." They get more business if people feel they are getting a discount at off-peak times rather than paying a surcharge at peak periods, even if the prices are identical. Cognitive psychologists have documented that doctors make different recommendations if they see evidence that is presented as "survival probabilities" rather than "mortality rates," even though survival probabilities plus mortality rates add up to 100%.

Representativeness

People underweight long-term averages. People tend to put too much weight on recent experience. This is sometimes known as the "law of small numbers." As an example, when equity returns have been high for many years (such as 1982-2000 in the U.S. and western Europe), many people begin to believe that high equity returns are "normal."